Keep Your Eyes Down the Runway

I lost both my parents last year, only 3 months apart. Their passing was not unexpected, and I was fortunate to have the support of a great family, friends, and colleagues. As time passes, grief has turned to gratitude for the tremendous love and unwavering support they provided to me, my four sisters, and their twelve grandchildren throughout our lives.

I found another source of that gratitude just a few weeks ago while cleaning out my father’s office. After he retired, my dad earned his pilot’s license and flew his own private plane for many years. In his office, I found a framed picture of him and his plane with a post-it note written in his own hand. The note said, “Look Down the Runway, Dummy! Keep Flying the Airplane.”

I recognized the note as the same one he had posted in the cockpit of his airplane. The tone was characteristic of a man who held himself to the highest standards but maintained a great sense of humor and humility. He had been struggling with his landings and the beginning pilot’s tendency to look over the nose of the airplane to judge their distance from the ground. This can cause the pilot to over control the airplane and cause the plane to balloon up or porpoise during the flare, resulting in hard landings. Instead, beginning pilots are taught to look down to the end of the runway during their approach, allowing better depth perception and alignment and resulting in smoother landings.

It occurred to me that this tendency to focus on what is immediately in front of you and to “over control” one’s portfolio is the biggest obstacle to long-term investment success. I consider it part of my job to help clients keep their eyes down the runway and focused on long-term trends and outcomes. That is especially true in today’s fixed income markets, where rising interest rates have caused short-term pain and led many to focus exclusively on the safety of Treasury bills and money markets. A longer-term view, I believe, shows that there is value today in intermediate and longer-term bonds, and investors should consider the benefits of locking high quality income.

Resilient, but for how long

The economy has been remarkably resilient this year. Second quarter GDP came in at 2.4% [Figure 1], faster than economists expected and above the 2% growth in the first three months of the year. Stronger business investment and solid consumer spending combined to push back expectations that a recession would start by mid-year as businesses and consumers faced higher interest rates.

Inflation, too, remains elevated. While inflation has come down from a 40-year high last summer, the consumer price index at 3% is too high for the Fed [Figure 2], especially with core inflation (excluding volatile food and energy) still up 4.8% from a year earlier. It is no surprise then that the Fed raised interest rates another 0.25 percentage point at its July meeting.

But while these data points show resiliency, we know that Federal Reserve policy works with a lagged effect and that credit conditions are finally tightening. The Fed's quarterly Senior Loan Officer Opinion Survey, or SLOOS, showed that banks reported tighter credit standards and weaker loan demand from both businesses and consumers during the second quarter and expect to further tighten standards over the rest of 2023.

We also know that it takes 23 months, on average, after the Fed first raises interest rates for the unemployment rate to increase. Since the Fed started to hike in March of 2022, it would be normal for employment to begin deteriorating toward the end of this year or in 1Q of 2024.

These lagged effects help explain the forward-looking portions (down the runway) of the two charts above. GDP forecasts, while improving, still show sub 2% growth over the next several quarters, and Treasury Inflation Protected Securities (TIPS) imply inflation declining toward the Fed’s 2% target. Long-term interest rates are a function of economic growth and inflation expectations, and with both expected to decline, interest rates are likely peaking.

Real returns in fixed income

If interest rates are peaking as we believe, fixed income investors stand to benefit from price appreciation by locking in interest rates that are near their highest levels in over a decade [Figure 3].

Yields are high today not only in nominal terms but also when compared to inflation expectations. In fact, the “real yield,” or the yield after adjusting for inflation, of the 10-Year Treasury today is the highest it has been since the Great Financial Crisis [Figure 4].

According to our partners at Columbia Threadneedle, since the Fed began to target inflation in the mid-1990s this “real yield” has averaged about 1.1%. If inflation falls to 2% as expected, this suggests that the 10-Year Treasury could fall from 4% today to 3%, or even lower in the event of a recession. Short-term rates would likely fall much further.

Smooth landing

Whether the Federal Reserve can bring inflation down without causing a recession (a soft landing), or whether it takes a recession to bring inflation down to target (hard landing) is impossible to predict. But a good investor, like a good pilot, should keep their eyes down the runway. Today that means stepping out of cash, taking advantage of the high real yields available in quality fixed income, and rebalancing portfolios that have become equity-heavy to their long-term targets. That is, in our view, the best way to ensure a smooth landing for your investment portfolio.